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Trains of Thought: Divergent Theories about Economic Crises

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The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

–John Maynard Keynes

During Thatcher’s only visit to the Conservative Research Department in the summer of 1975, a speaker had prepared a paper on why the “middle way” was the pragmatic path the Conservative Party should take, avoiding the extremes of left and right. Before he had finished, Thatcher “reached into her briefcase and took out a book. It was Friedrich von Hayek’s The Constitution of Liberty. Interrupting our pragmatist, she held the book up for all of us to see. ‘This,’ she said sternly, ‘is what we believe,’ and banged Hayek down on the table.”

–Wikipedia 2010, quoting Ranelagh 1992, ix

Recently, the Economist (2010) suggested taking a fresh look at the Austrian School Theory (AST) of economic crises. In a nutshell, AST attributes economic crises to credit laxity, which creates an excess capacity through periods of economic expansion. Under the law of diminishing returns, expanding supply chases stagnating demand until credit risks are repriced to conform to a new situation. Crises occur because the financial markets, unlike the real markets, are able to turn on a dime by instantly incorporating new information. There is an inevitable time lag between the nearly immediate and easily reversible decisions in the financial sector and the relatively hard-to-undo decisions in the real sector of the economy. This theory was developed by Ludwig von Mises, a student of Eugen von Böhm-Bawerk and brother of applied mathematician Richard von Mises. Mises’ student Friedrich von Hayek developed the theory further and won a Nobel Prize in Economics in 1974.

Despite its star-studded authorship, AST became a Cinderella of economic theory, dismissed by economists on the right (e.g., Milton Friedman) and the left (the neo-Keynesians, including Hayek’s own student Nicholas Kaldor). Neoclassicists could not accept the idea that businesses can make wrong decisions, at least not en masse. Post-Keynesians, who could reconcile themselves to the lags between investment and output, observed that, empirically, crises happen in the opposite sequence: relatively high (nominal) interest rates accompany the expansion period of the cycle, while relatively low interest rates are characteristic of recessions. The proof that real interest rates always move in the direction opposite to nominal rates is hardly more transparent than the theory itself. Moreover, when interest rates hover around zero, as in Japan since the late 1980s and in the US today, it is hard to advance the case of positive real interest rates reflecting enhanced credit risks.

But AST leaves a fundamental question unanswered: if credit expansions cause cycles, what causes credit expansions? If the Earth is standing on three elephants standing on a tortoise’s shell, where does the tortoise find its support?

One of the most poignant observations about AST is that its explanation of economic cyclicality is proposed by the Marxist economists. The cornerstone of Marxist economic theory is the lag between demand shocks and the real investment shocks in supply. To my knowledge, Mises never acknowledged his debt to Karl Marx. This was in contrast to another eminent Austrian economist, Joseph Schumpeter, who always maintained that he borrowed his concept of long-term cyclicality (now called “Schumpeter cycles”) from the Russian-Soviet (non-Marxist) economist Nicolai Kondratiev. And Mises’ acquaintance with Marxist teachings was not accidental for all his professed contempt: Böhm-Bawerk wrote refutations of the Marxist (i.e., Ricardian) theory of value and labor exploitation in several obtuse volumes. Obviously, Böhm-Bawerk considered it intellectually credible enough to warrant the time thus spent.

Heterodox—i.e., other than neoclassical—theories of cycles went out of fashion with 1970s stagflation, with which they were obviously incompatible. Neoclassicism and monetarism came back into vogue because the belief that there is no economic cyclicality, only external shocks, fit very well into the pattern of rising oil prices and budget deficits (deficits that are laughable by contemporary standards). Ultimately, the neoclassical view triumphed because it enunciated just what business wanted to hear.

Recently, crises have returned to a more predictable pattern: inflation and interest rates rise during an expansion and fall during a recession. If (financial) markets are efficient, credit spreads must compensate for diminishing returns on expanded production. Hence, heterodox economics have acquired intellectual currency again. The prevailing modern view—championed by Christina Romer, co-head of the NBER Monetary Economics Program, among others—is that economic cycles seem to be produced by random shocks but (in contrast to the Chicago-school interpretation) are real in the sense that many economic indicators, including employment, monetary stock, and interest rates, tend to co-move. Finally, in a nod to the Keynesian explanation, general opinion says that a slowing of real business activity predates a monetary squeeze rather than the other way around.

The two strangest figures in the entire story, Polish economist Michał Kalecki and Russian-Soviet mathematician Eugen Slutsky, worked at a time when their respective nations were backwaters for theoretical economics. Kalecki was nominally a Marxist but performed most of his groundbreaking work in pre–World War II Poland, which was ruled by anti-Communist military strongman, as were the majority of eastern and southern European nations of the time. Kalecki proposed that economic cycles are the result of democratic election cycles: regardless of ideology, the party in power makes unsustainable monetary promises to stay in power, creating inflation of the money supply to be sterilized in a subsequent crisis.1 We have seen this play out in the recent financial meltdown and its aftermath, as banks are receiving credit at very low (zero) rates but are not lending—a state of affairs that is hard to reconcile with neoclassicism. This is viewed by the “Economist” observer as an argument for the resuscitation of AST. But, foregoing marginal and peripheral EU economies (Iceland, Hungary, Estonia), it is difficult to assume that the credit bonanza and its consequence—overblown financial sectors of these economies—were the major contributors to the debacle.

Slutsky began his career in economics during World War I, when the Russian Empire was allied with Italy, the country where he published his first work. His most productive years were the 1920s, when Communist orthodoxy had not yet solidified. He claimed that the summation of random variables can, in some cases, lead to quasi-periodic behavior—hence, the cyclical crises and revivals. He managed to fly under the radar of the Stalinist authorities and died in his bed, unlike Kondratiev, who faced a firing squad.

Since the rediscovery of Slutsky’s work—partly due to the efforts of Keynesian Paul Samuelson, the first American Nobelist in Economics—“Slutsky decomposition” and “Slutsky theorem” are concepts included in most textbooks on microeconomics and econometrics. Yet, Slutsky’s prescient view on the business cycle has been subsumed into monetarist theory. If business cycles are just a statistical illusion similar to rogue ocean waves, as strict Chicago-school constructionists would argue, why do sales of toys, for instance, and laying the ships seem to go into peaks and troughs rather synchronously? Common-sense answers tend to gravitate towards aggregate supply-and-demand explanations—i.e., the currently deprecated Keynesianism.

In this article I attempt to show how uncomfortable it is to view macroeconomics as “scientific.” A journalist from the Economist can resuscitate a debate begun by some “economist being defunct decades ago,” marveling that not all the smart people were born before the Internet. It seems that economic theories go in and out of fashion following their own inscrutable cycles. In the premodern period of medical science, the situation was much the same, with warring schools and nearly deified authorities such as Galen and Erasistratus. Yet, if economics is not a liberal art similar to literary criticism, for instance, then it should explain the basic facts of economic life without reference to particular schools and opinions of individual scientists.


Economist. November 18, 2010. “Taking von Mises to Pieces: Why Is the Austrian Explanation for the Crisis So Little Discussed?” 

Ranelagh, John. 1992. Thatcher’s People: An Insider’s Account of the Politics, the Power, and the Personalities. London, England. Fontana.

Wikipedia. Last modified December 28, 2010. “Friedrich Hayek.” 

Peter Lerner, PhD, MBA is a semi-retired financial researcher who lives in Ithaca, NY. Last semester he taught Business Statistics in one of New York’s MBA programs.

1. Technically, these are monetary aggregates [M1–M3] that are sterilized. The scenario how it happens is not unique and depends on particular economic situation. For instance, during the current recession, real assets—i.e., houses—are depreciating to a degree at which the aggregate money supply seems to be “recatching” the demand on the way down through the wealth effect.

As an impartial, nonprofit forum for the finance and banking industries NYSSA encourages discussion and debate among its member and other professionals. Commentaries, however, should be taken as the sole opinion of the author(s) and not of NYSSA. If you would like to submit a commentary to the Finance Professional's Post, send your article to the editor.

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The Austrian School does give a reason for cycles: It is Credit Expansion which results in artificially low interest rates.
These low rates lead entrepreneurs into over-expanding their businesses because the returns on their investments (given the cheap money) look higher than they will be in the long run, when money returns to its real cost.
That is exactly what happened before the last recession (and previous ones), when the US Fed (and many other central banks) flooded their economies with money and its cost became too low...
By the way, the AST does not say it is science in the way physical sciences work because human action is interactive, not individually forecastable nor are individual's actions identical.
The great mystery is why entrepreneurs competing with each other, can collectively get things right. For example, 5 competitive shoe companies produce fewer wasted (mis-sized) shoes than a centrally-planned government operated factory run by a highly-regarded professional...

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